Reporting of Passive Foreign Investment Companies Effective for the 2013 Tax Year

Rödl & Partner Tax Matters Vol 2014 – 5, republished in July 2024

On December 30, 2013, the IRS published proposed, temporary, and final regulations relating to Passive Foreign Investment Companies (“PFICs”) and their shareholders. The most significant outcome is that, with limited exceptions, annual PFIC reporting is now required for all PFICs beginning with the 2013 tax year. While the PFIC tax regime has been around for many years, some taxpayers may still be unaware of its requirements.

Taxation of PFICs

Generally, the U.S. doesn’t tax foreign business income derived by a foreign corporation with U.S. shareholders until the corporation makes a dividend distribution to those shareholders. Certain rules, however, eliminate the benefit of deferral of U.S. tax on income derived through foreign corporations. These rules include the PFIC regime.

Generally, U.S. shareholders of PFICs pay U.S. tax and an interest charge on the receipt of “excess” distributions and upon the disposition of PFIC stock. Excess distributions are the portion of the distribution received during the current tax year that is greater than 125% of the average distributions received during the 3 preceding tax years (or the holding period if less than 3 years). Absent certain elections, gain recognized on the disposition of stock in a PFIC or on receipt of excess distributions is treated as ordinary income and as earned pro rata over the shareholder’s investment holding period.

As alternative to the general rule, U.S. shareholders may elect to treat the PFIC as a qualified electing fund (“QEF”) or to be taxed under the mark-to-market rules applicable to marketable PFIC stock. If an election is made to treat the PFIC as a QEF, then each U.S. shareholder must generally include his or her share of the PFIC’s total income in gross income on an annual basis.

As a practical matter it may be difficult to obtain information regarding the earnings of the foreign corporation computed on a U.S. tax basis.

Finally, a shareholder of a PFIC may make a mark-to-market election for marketable PFIC stock. Under the mark-to-market rules, U.S. shareholders currently take into account as income (or loss subject to certain limitations) the difference between the fair market value and their adjusted basis of the stock as of the close of the tax year.

What is a PFIC?

A foreign corporation is a PFIC if it meets either the income or asset test described below.

Income test: 75% or more of the corporation’s gross income for its taxable year is passive income (e.g. Dividends, interest, royalties, rents, and annuities, among a few others).
Asset test: At least 50% of the average percentages of assets held by the foreign corporation during the taxable year are assets that produce passive income or that are held for the production of passive income.

Average percentage of assets is generally based on fair value of the assets unless the use of the adjusted basis (as determined for E&P purposes) is elected. Publicly traded corporations must use fair value; controlled foreign corporations (“CFC”) must use adjusted basis.

Many foreign mutual funds are considered PFICs.

Indirect ownership and Controlled Foreign Corporations

When determining if a foreign corporation that owns at least 25% (by value) of another corporation is a PFIC, the foreign corporation is treated as if it held a proportionate share of the assets and received directly its proportionate share of the income of the 25%-or-more owned corporation.

A 10% U.S. shareholder that includes in income its pro rata share of the subpart F income of a CFC that is also a PFIC generally will not be subject to the PFIC provisions for the same stock during the qualified portion of the shareholder’s holding period of the stock in the PFIC. A CFC is a foreign corporation more than 50% controlled by 10% U.S. shareholders.

PFIC Reporting Requirements

Generally, a U.S. person that is a direct or indirect shareholder of a PFIC must file Form 8621 for each tax year it owns any percentage of the shares of a PFIC. In addition, certain shareholders owning PFIC shares indirectly through a U.S. entity are required to file Form 8621 if the indirect shareholder:

Receives direct or indirect excess distributions from a PFIC,
Recognizes gain on a direct or indirect disposition of PFIC stock,
Is required to include an amount in income with respect to a QEF or mark-to-market election, or
Is making a QEF or mark-to-market election.

There are certain exceptions from filing. Notably, if the aggregate value of the shareholder’s PFIC stock owned directly or indirectly is $25,000 or less, or the value of the shareholder’s indirect PFIC stock is $5,000 or less reporting is not required. In both instances, in order to take advantage of the exception, a QEF or MTM cannot be made and the shareholder must not be treated as having an excess distribution with respect to the PFI.

A separate Form 8621 must be filed for each PFIC in which stock is held, directly or indirectly. The filing of Form 8621 eliminates the need to report the asset on the Statement of Specified Foreign Financial Assets – Form 8938, but the filing of Form 8621 and the number of Forms 8621 included must be identified on Form 8938.

The PFIC reporting regime is a complex and often overlooked area of U.S. taxation. The statute of limitations does not begin run for a return that does not included the required PFIC reporting. Taxpayers should analyze their investments and consult with their tax advisors to ensure proper reporting of their foreign holdings.

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